7.3.2. Inflation, Interest Rates, and Availability of Credit
During the later stages of an expansion, demand for goods begins to exceed supply. This can occur because of any of the following:
- • High consumer confidence
- • An economy that has reached its potential to increase production
- • Excess money in the economy, either because of government policy or external events
With an overheated economy, inflation appears. Inflation is an increase in the prices of goods and services and a decline in the purchasing power of a currency. With inflation comes rising interest rates. If the cost of living is increasing at 5%, investors will be unwilling to purchase a bond paying 4% and lose purchasing power. Lenders respond to inflation by raising both interest rates and loan qualification requirements. As a result, credit tightens.
In an inflationary environment, investors may be less inclined to make long-term investments. The possibility that a long-term bond or other long-term investment may not keep up with inflation may drive investors to short-term and variable-rate bonds. Unfortunately, in order to grow, many businesses, especially capital-intensive companies, such as oil and gas refineries, airlines, and telecommunications companies, need to borrow for the long-term, so an inflationary environment can reduce business investment.
For all of these reasons, inflation contributes to the end of an expansion and the beginning of a contraction. In the early stages of a contraction, credit remains tight and interest rates high, but as inflation drops, interest rates start to come down as well. In the later stages of a contraction, when the Federal Reserve Board buys government securities—thereby injecting money into banks and other lenders—credit loosens and interest rates fall further.
Bond yields follow the interest rate pattern: they rise in the later stages of an expansion and fall in the later stages of a contraction. Furtherm